The Sixth Estate

One of the most phenomenal aspects of the stock market mayhem of the past two years was the discovery that the American Securities and Exchange Commission (SEC) is one of the most inept law enforcement organizations in the country. There have still been virtually no prosecutions or lawsuits, despite evidence of massive fraud. Despite large amounts of evidence being presented to them by concerned outsiders, the largest fraud in history, that of Bernie Madoff, was similarly missed.

The SEC possesses an outside oversight body, an Inspector-General, who monitors the organization, identifies wrongdoing, and makes recommendations for improvements. Most of the reports are public and unclassified, and most of them even (used to) appear on the organization’s website. Curiously, however, not all of them do. In fact, some of them were even removed from the website, according to the Project on Government Oversight (POGO).

POGO has therefore done us the invaluable task of returning the past three years’ worth of investigative reports to the Internet. Its list includes 20 reports not disclosed to the public, and 8 reports that are still on the public website.

The documents paint a fairly disturbing picture of the organization. To be sure, there are 2000 people working for the SEC, and like any other law enforcement organization, the corruption of a few is not necessarily an indictment of the many. However, as with any other law enforcement organization, the apparent ability of these people to continue in their duties until caught by an outsider with enough influence to make charges stick does raise questions about the trustworthiness of the organization.

The Inspector-General investigates a wide range of problems within the SEC. The released reports include investigations into allegations of discrimination against applicants and employees, corrupt practices within the service, and failures to properly investigate major frauds, including the Bernie Madoff Ponzi scheme.

I’m not going to discuss the major reports, for the most part, because they’re lengthy and I haven’t had time to read them yet. The exception is the following report on David Einhorn, because until now it had been blocked from the public.

This case involved David Einhorn, a hedge fund manager at Greenlight Capital who publicly accused a far larger and more influential company, Allied Capital, of investment fraud, and followed that up with a book about how investment banking was rife with fraud and the SEC was deliberately looking the other way, called Fooling Some of the People All of the Time. The investigation began after the Wall Street Journal reported that an SEC employee stepped down to take up a new job at Einhorn and took SEC material with him, including records showing that the SEC was monitoring Einhorn’s phone calls.

Why, you ask? Well, this report explains why. In May 2002, Einhorn gave specific details of alleged Allied Capital investment fraud (overvaluing investments and then announcing false, inflated results). Allied Capital sprang into attention through its close contacts with the SEC:

Allied’s [redacted] had worked for the SEC, and [redacted], a former SEC Commissioner, later served as a senior advisor to Allied… BDCs have “a lot of contacts on the 10th floor,” meaning with the SEC Chairman and Commissioner, and in Congress…

Allied requested a meeting with Enforcement in June 2002 to try to convince them to investigate Einhorn… Allied’s [redacted] was there, as was [redacted], who was representing Allied… The result of the meeting, [redacted SEC official] said, was that the facts presented two possible wrongdoers: Einhorn or Allied. The [redacted official] testified that he took the position that Allied should be investigated. But instead, Enforcement started investigating Einhorn first.

To sum up, Einhorn provided (publicly, and privately to the SEC) evidence that Allied, a much larger and more influential company, was breaking the law. In response, law enforcement met with Allied, who presented evidence that Einhorn might have been breaking the law, too. In response, the SEC decided to hold off on its Allied investigation and target Einhorn instead. He was innocent, as it turns out, and eventually, a year later, the SEC got around to investigating Allied again.

This wasn’t their first investigation, as it turned out. In 2001, Allied was targeted by two SEC teams, but both quickly closed the cases, one because “difficult accounting issues prevented a ‘quick hit’” and the other because Allied’s practices seemed to “involve a ‘very notoriously grey area.’” The new investigation made no reference to evidence supplied by Einhorn, and quickly closed again. Afterwards, an unnamed official who was part of the investigations stepped down from SEC and and took a job with Allied:

he took with him a “memo pad of notes,” “personal logs” and calendars from his time at the SEC.

This included private information about Einhorn and Greenlight Capital, which he promptly shared with their enemy, Allied. Shortly afterward,

[Einhorn] discovered that his wife’s (Cheryl Einhorn’s) telephone records were taken… He was told a woman called AT&T and identified herself as “Cheryl Einhorn” and used her social security number to open an online billing account for his home telephone. According to Einhorn, the caller directed the phone company to send copies of Einhorn’s home telephone bills to an AOL account.

This is called identity theft, and it is a crime. Allied first denied it had happened, and then admitted that it had but that the misconduct had been done by a low-level “agent” without the knowledge or approval of senior management. The SEC decided not to investigate how Allied obtained Einhorn’s phone records.

In the meantime, it also botched the Allied investigation, too. It ostensibly lasted almost two years, between late 2002 and 2004. Although the Allied building was only a few blocks from SEC headquarters, investigators testified that at no time did they ever visit the company to interview managers and employees or review documentation.

Allied Capital is a particular type of investing company called a Business Development Corporation (BDC). The investigation found that such companies are rife with legal problems:

According to [redacted], “My view of BDCs is every one of them is an enforcement case waiting to happen.” Yet, [the SEC] does not currently have a system for attributing risk profiles for investment companies, only investment advisors… According to [redacted], although BDCs are considered high risk firms, there is no designated time frame in which BDCs are examined by the SEC. Therefore, according to [redacted], BDCs can go more than five years without being examined.

Allied, moreover, was the largest BDC in the market at the time. Despite this, the chief investigator was a new and inexperienced official, who admitted she thought her assignment was a “strange” one. Allied’s representatives at the handful of meetings that did occur, all at SEC, were (purely by coincidence, I’m sure) picked from Allied’s pool of former SEC law enforcement officials. There’s a good reason for this: when asked by the Inspector-General, SEC investigators said that they “believe that someone in the industry who used to work at the SEC is more likely to be fair and honest.”

The investigation bogged down, went nowhere, and eventually was closed. Then the SEC files on the matter were “lost”:

[Redacted] agreed to give testimony under oath that same day. [Redacted] informed the OIG [Office of the Inspector-General] that all of her Allied files were gone from the shared “J:” drive where OCIE examiners kept their examination work papers and reports… her Allied file included spreadsheets she created, the examination report, copies of relevant interoffice memos, information from [redacted] and relevant e-mails…

After [redacted] realized her Allied file was gone from the “J:” drive, she told her [redacted]. Upon hearing that the files were missing,… [redacted] was surprised at how many files had been deleted. [Redacted] testified she and [redacted] met with [redacted] to tell him that the Allied file was missing from the “J:” drive… [Redacted] did not seem very surprised or even concerned and responded, “Oh. Your files were deleted? Well,… then we’ll figure out what we’re going to do.”

[Redacted] did not think [redacted's] reaction to the news was normal. Two days later… [she] learned that OIT could only go back 30 days to recover documents, which [redacted] found amazing. [Redacted] testified, “Deep down I do think somebody purposely deleted the Allied file. I don’t think it was an accident.”

Eventually another branch of SEC conducted a “proper” investigation of Allied, though it was limited to certain narrow aspects of how they valued investments, rather than the broader questions Einhorn initially brought up, which amounted to very serious fraud. This investigation closed with a vague settlement, in which Allied promised that it would no longer violate laws regarding keeping accurate financial records, agreed to hire a “Chief Valuation Officer,” and was absolved of previous illegal actions without penalty. Voila!